Capital Controls Notes

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Capital Controls Revision

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Pip Reeve IEMT10W7T6 "Capital controls give policymakers an extra degree of freedom." Is this a decisive argument in favour of having capital controls?
Many different kinds of actions have been designed in order to influence international capital transactions. Cooper (1999) defines the term 'capital controls' as 'the subclass of these actions that involve quantitative restrictions, as opposed to those that allow unlimited transactions, but at a price penalty. In April 1997, the International Monetary Fund (IMF) proposed that its Articles of Agreement be amended in order to include currency convertibility for capital transactions among its fundamental objectives, suggesting that they do not necessarily agree with the fundamentals of this statement, and instead believe in a more liberalised capital market. Capital account convertibility by no means implies a complete freedom of international capital movements; however, it does imply a reduction in capital restrictions such as price discrimination through multiple exchange rates and requiring non-interest bearing reserves against certain capital inflows. In this essay I propose that capital controls can be a beneficial policy instrument at certain stages of development, if implemented effectively. Overall, there are both many advantages and disadvantages to capital market liberalisation and it is clearly a complex issue. I believe that the advantages possibly outweigh the disadvantages and so the extra freedom gained for policymakers from capital controls does not necessarily mean that they should be favoured. It seems that at one extreme there is the idea of complete financial market liberalisation with the possibility of a single currency and no limits on the quantity of capitals that can be exchanged. At the other extreme, there is the idea of capital controls, with each country having their own exchange rate and limiting the amount of capital which can be transferred between two countries. Grauwe presents the Mundell (1961) model and suggests that 'when a country relinquishes its national currency, it also relinquishes an instrument of economic policy.'1 Taking the example of a shift in consumer preferences away from French made to German made products, output in France will decrease and in Germany it will increase. The value of domestic output in France decreases and, if spending by French residents doesn't decrease by the same amount, there will be a current account deficit. This is likely as unemployment benefits will prevent disposable income from decreasing by the same amount as the decreases in output, however, this will lead to an increase in the French government budget deficit. There are two mechanisms that will automatically bring the two countries back into equilibrium. The first of these is wage flexibility, where unemployed French workers will decrease their wage claims which will decrease aggregate supply and decrease the price of output making French products more competitive, stimulating demand and improving the French current account. In Germany, excess labour demand will increase the wage rate and its products will become less competitive. The second equilibrating mechanism is mobility of labour where the French unemployed move to Germany where there is excess labour demand. The French unemployment problem disappears and inflation wage pressures in Germany vanish. Current account disequilibria will also reduce, because the French were spending without producing in the form of unemployment benefits. If neither of these two mechanisms occur, the economy might get stuck in disequilibrium. If the Germans want to avoid inflation they must adopt restrictive monetary and fiscal policies However, if these policies are adopted, the current account surplus will not disappear. This disequilibrium can only be solved by revaluing the exchange rate which will reduce the demand in Germany and increase the competitiveness of French products. If they were in a monetary union with no capital controls and a single currency, this wouldn't be possible. So, in some ways this leads us to believe that the ability to have some capital controls is a very useful policy instrument. However, one major criticism of this model is that it is unlikely that a demand shock will be concentrated in one country. In fact, Grauwe claims that 'trade integration in fact may lead to more concentration of regional activities than less.' There are a number of cons of financial liberalisation which can mean that a lack of capital controls can reduce the freedom of policy makers. So, for example, financial liberalisation can 'limit the capacity of national monetary authorities to engage in countercyclical monetary policy.'2 This is because they can no longer 1 'The Economics of Monetary Integration' Grauwe 1997 2 'Should capital controls be banished?' Cooper 1999

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